Thursday, May 7, 2009

the chief impact of QE will come through the equity market

From Alphaville:

The ‘QE’ stockmarket effect

On paper, the Fed and Bank of England initiated quantitative easing policies to try and keep long-term yields down and to boost the level of aggregate banking sector reserves so as to encourage bank lending. So far, QE appears to be having variable success in achieving these two objectives.

As Stephen Lewis at Monument Securities writes on Thursday, in the UK the 10-year benchmark yield has now risen above the level where it stood when QE was announced. On the banking sector reserves front, meanwhile, there isn’t really enough monetary data for the period since QE began to judge.

But, as Lewis also points out, QE may be having another, perhaps less expected, but nonetheless still very welcome effect - on equities. As he explains (our emphasis):
Possibly, the chief impact of QE will come through the equity market. If ‘other financial institutions’ see their bank deposits increasing, they may be inclined to commit some of these funds to equity investment.

Since QE was initiated, the UK equity market has enjoyed a sharp rally. The Federal Reserve’s purchases of Treasuries may be having a similar effect on US equities. If equity prices are rising, and equity finance is becoming cheaper for companies, this would be a welcome result for UK policymakers. The MPC’s question regarding what happens to capital market values when QE ceases might still be pertinent. However, it might properly relate to equity prices rather than to gilt yields.

Related links:
BoE expands QE - FT Alphaville
The return of the yield?
- FT Alphaville
US Treasuries, not treasured by Fed, or Gross - FT Alphaville


Don the libertarian Democrat May 7 15:38
From Brendan Brown in the FT:

"The central bank and government, by devising a system in which such negativity can express itself, can give a big fillip to the recovery process.

The most direct channel for this fillip most likely passes through the equity market.

Pervasive negative risk-free rates across the advanced economies would underpin equity market levels.

Investors faced with certain substantial nominal loss on risk-free holdings would bid up the price of equity which could offer rich risk premiums even at a presently feebly level of prospective earnings.

And it is equity market developments which hold the key to the economic recovery."

And Martin Wolf's reply:

"Martin Wolf: This is ingenious and would, no doubt, permit negative real interest rates. But I would prefer it if vigorous action were taken by the monetary authorities to sustain inflation, before deflation set it, in which case we would never need negative nominal interest rates in order to obtain negative real rates.

If it is already too late for this, I agree that this scheme would make it possible for the authorities to impose negative real short rates. Another justification for negative real rates is that it would reduce the danger of debt deflation - the rising real level of debt as the price level falls. It would be wildly unpopular, of course, among politically powerful savers. It would have to be pointed out that this loss is offset by the rising real value of nominal claims.

But would it work in the way Brendan suggests? I am not sure. Equity markets might rise a little. But I very much doubt whether companies would start to issue equity in order to invest in a substantial way, in the midst of a deep recession. The underlying logic is Hayekian. I have never been convinced of this theory of the credit cycle.

So is there an alternative? Yes. The central bank can lend directly to the government, which can spend on investment and public consumption or make transfers to consumers to spend. If real interest rates were negative, this would be even cheaper for the government. That would certainly add to the effectiveness of such a policy, in any case."

From my perspective, Brown is correct, as Negative Interest Rates would be a disincentive to buy bonds, and an incentive to buy stocks for the longer term. QE that leads to very low interests rates now and higher interest rates in the future, as is happening now, should have the same effect. Why? You should invest in stocks when bond yields are low, and switch when bond yields are high. There are good reasons for the current rise in stock prices, although I have no idea if it is too much and too fast.

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